If You Sell Marijuana in Any Form, Uncle Sam Wants His Cut

More and more states across the country are legalizing the sale of marijuana products for medical and/or recreational purposes, but marijuana remains effectively prohibited under federal law as a Schedule I controlled substance within the meaning of the federal Controlled Substances Act of 1970.

There is, however, one important and practical exception to that prohibition: The federal government recognizes marijuana companies for purposes of the federal income tax law, and these businesses must pay their share of federal taxes. This is so even though marijuana enterprises currently have limited banking access, which results in most of them conducting business transactions in cash only.

As marijuana moves further into the mainstream, as income and sales projections continue to increase and as the government seeks additional sources of revenue, the taxation of marijuana enterprises will become more of a concern for marijuana businesses.

The Tax Code

The Internal Revenue Code imposes a tax on income from both legal and illegal sources.  Federal courts have consistently upheld IRS determinations that state-compliant marijuana dispensaries have taxable income. (It also is worth nothing that businesses that may be operating illegally under federal law are not exempt from their federal employment tax obligations, i.e. Social Security and Medicare taxes.)

In addition, the Code generally prohibits the deduction of expenses incurred in selling Schedule I controlled substances, such as marijuana. However, the Code permits the deduction of the cost of goods sold from gross revenue.

Cost of goods sold for producers includes direct material cost, for example, marijuana seeds or plants; direct labor costs such as for planting, cultivating, harvesting and sorting; and indirect costs. Indirect costs may include repair expenses, maintenance, utilities, rent, indirect labor and production supervisory wages, indirect materials, tools and cost of quality control.

The IRS also has said that the cost of goods sold for retailers includes the costs of the marijuana purchased, less trade or other discounts, plus transportation or other necessary charges in acquiring possession of the marijuana. However, cost of goods sold does not include marketing, advertising, selling expenses, distribution, interest expense or various other costs. If these costs are included as part of costs of goods sold, they would be disallowed as an “adjustment,” which would increase the taxable income and tax obligations of the business.

The IRS has a page on its website that provides general guidance for taxpayers in the marijuana industry.

The IRS website also has answers to frequently asked questions for the marijuana industry, including an explanation of the payment plans available to marijuana companies that cannot fully pay the amount they owe; penalties or additions that a participant in the marijuana industry could be subject to if adjustments are made during an income tax audit; and the steps to take for cash payments over $10,000.

An Open Issue

The Tax Cuts and Jobs Act of 2017 added a new section to the Code that is applicable to taxable years after December 31, 2017, for small businesses with less than $25 million in gross receipts. Under this new provision, marijuana businesses may be able to argue they are entitled to use a method of accounting that includes all expenses in cost of goods sold. The effect of the law on marijuana companies is still unclear, and the IRS has not indicated when it intends to issue guidance on this issue.

Looking to the Future

As more states vote in favor of legalization, with revenue undoubtedly on their minds, and as the federal government focuses on taxation, 2021 is likely to see significant developments in this area.